Traditionally, business owners have turned to the insurance industry for protection against risks associated with their professions, including malpractice litigation and product liability. As a result, insurance companies have been able to charge high premiums for their services. But what if business owners started their own?
Smart Business spoke with Christopher Axene, CPA, a principal at Rea & Associates, to learn about captive insurance companies and how they can be used to help business owners lower their taxes while increasing wealth.
What is a captive insurance company and how can it be used as a tax planning tool?
Captive insurance occurs when a company or service professional purchases insurance coverage from an insurance company they also own and control, and this can be a desirable option for many business owners.
The captive insurance option allows business owners to pay insurance premiums to their own insurance company and claim the tax deduction associated with this expense as they normally would. But instead of paying another insurance company, they pay the premiums to themselves.
Furthermore, because of a provision in the tax law, the captive insurance company doesn’t pay taxes on the premium income it collects, as long as the premiums total no more than $1.2 million per year.
Another tax consideration for those interested in starting their own captive insurance company is that at the end of the coverage term, the unspent premiums can be reinvested and any dividends received will be taxed at a significantly reduced rate. The law says that captive insurance companies can deduct 70 percent of the dividends they receive from stock portfolio investments.
Is a captive insurance company still a valid safeguard against risk?
To be considered ‘insurance’ and a valid safeguard against risk by the IRS, the captive insurance company must meet two qualifying factors — risk shifting and risk distribution. Risk shifting means that risk can be shifted from the business to the captive insurance company.
Achieving risk distribution is a little harder because it means that the captive insurance company must be a part of a risk distribution system — a group of captives that share each other’s risks. Typically, the premiums one would pay into their insurance are used to safeguard their business against smaller risks. For larger issues, such as a malpractice claim, funds to help settle the claim would be pulled from the distribution pool.
How do I know if a captive insurance company is the right strategy for my business?
Business owners across all industries are eligible to establish a captive insurance company, but certain factors may make this strategy more desirable to larger companies. First, upfront costs should be considered. This would include any research conducted on the business, service fees and any legal considerations associated with setting up the entity. But once it’s established, there are service providers that are available to manage the captive, giving business owners the freedom to concentrate on their business.
Second, while a captive insurance company can help an owner realize significant tax savings and increase wealth, using this entity as a tax planning strategy is only possible if few (or no) claims are made against their business — at least during the first few years to give the owner time to reinvest the premiums they originally paid into the captive.
In other words, if an owner sets up a captive insurance company and is forced to make a claim in the first year or two, the owner may wind up diminishing the account and owing more than what the owner has, which isn’t an optimal outcome for anybody.
When done properly, a captive insurance arrangement can provide business owners with a cheaper insurance coverage solution. At the same time, when claims history is low, the profits of the captive can be reinvested for the owner’s benefit.
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